SECTION 5. APPLICATION — Internal Revenue Bulletin 2005-24

SAFE HARBOR TO SERVICE PROVIDER AND SERVICE RECIPIENT

.01 Application of Safe Harbor to the Service Provider . Under the Safe Harbor, the service provider recognizes compensation income upon the transfer of a substantially vested Safe Harbor Partnership Interest in an amount equal to the liquidation value of the interest, less any amount paid for the interest. If the service provider receives a Safe Harbor Partnership Interest that is substantially nonvested, does not make an election under § 83(b), and holds the interest until it substantially vests, the service provider recognizes compensation income in an amount equal to the liquidation value of the interest on the date the interest substantially vests, less any amount paid for the interest. If the service provider receives a Safe Harbor Partnership Interest that is substantially nonvested and makes an election under § 83(b), the service provider recognizes compensation income on the date of transfer equal to the liquidation value of the interest, determined as if the interest were substantially vested, pursuant to the rules of § 83(b) and § 1.83–2, less any amount paid for the interest.

.02 Application of Safe Harbor to the Service Recipient . Under § 83(h), the service recipient generally is entitled to a deduction equal to the amount included as compensation in the gross income of the service provider under § 83(a), (b), or (d)(2), but only to the extent the amount meets the requirements of § 162 or § 212. Under the Safe Harbor, the amount included in the service provider’s gross income in accordance with section 4.02 of this revenue procedure is considered the amount included as compensation in the gross income of the service provider under § 83(a) or (b) for purposes of § 83(h). The deduction generally is allowed for the taxable year of the partnership in which or with which ends the taxable year of

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Although SP must surrender the partnership interest upon termination of services to the partnership, SP will not surrender any share of the profits accumulated through the end of the partnership taxable year preceding the partnership taxable year in which SP terminates services.

Conclusion : Under section 4.03 of this revenue procedure, SP ’s interest in PRS is treated as substantially vested at the time of transfer. Under section 4.02 of this revenue procedure, the fair market value of the interest for purposes of § 83 is treated as being equal to its liquidation value (zero). Therefore, SP does not recognize compensation income under § 83(a) as a result of the transfer, PRS is not entitled to a deduction, and SP is not entitled to a capital account balance.

(2) Example 2: Substantially Vested Interest Facts : PRS has two partners, A and B, each with a 50% interest in PRS . On March 1, 2005, SP pays the partnership $10 and agrees to perform services for the partnership in exchange for a 10% partnership interest that is treated as substantially vested under section 4.03 of this revenue procedure. Immediately before SP ’s $10 payment to PRS and the transfer of the partnership interest to SP in connection with the performance of services, the value of the partnership’s assets (including goodwill, going concern value, and any other intangibles associated with the partnership’s operations) is $990.

Conclusion : Under section 4.02 of this revenue procedure, the fair market value of SP ’s interest in PRS at the time the interest becomes substantially vested is treated as being equal to its liquidation value at that time for purposes of § 83. Therefore, in 2005, SP includes $90 ($100 liquidation value less $10 amount paid for the interest) as compensation income under § 83(a), PRS is entitled to a deduction of $90 under § 83(h), and SP ’s initial capital account is $100 ($90 included in income plus $10 amount paid for the interest).

(3) Example 3: Substantially Nonvested Interest; No § 83(b) Election; Pre-Existing Partner

Facts : PRS has two partners, A and SP, each with a 50% interest in PRS . On December 31, 2004, SP agrees to perform services for the partnership in exchange for a 10% increase in SP ’s interest in the partnership from 50% to 60%. SP is not required to pay any amount in exchange for the additional 10% interest. Under the terms of the partnership agreement, if SP terminates services on or before January 1, 2008, SP forfeits any right to any share of accumulated, undistributed profits with respect to the additional 10% interest. The partnership interest transferred to SP is not transferable and no election is made under § 83(b). SP continues performing services through January 1, 2008. PRS has taxable income of $500 in 2005 and $1,000 in each of 2006 and 2007. No distributions are made to A or SP during such period. On January 1, 2008, the value of the partnership’s assets (including goodwill, going concern value, and any other intangibles associated with the partnership’s operations) is $3,500.

Conclusion : Under section 4.03 of this revenue procedure, the 10% partnership interest transferred to SP on December 31, 2004, is treated as substantially nonvested at the time of transfer. Because a § 83(b) election is not made, SP does not include any amount as compensation income attributable to the transfer,

and correspondingly, PRS is not entitled to a deduction under § 83(h).

In accordance with the partnership agreement, PRS ’s taxable income for 2005 is allocated $250 to A and $250 to SP, and PRS ’s taxable income for each of 2006 and 2007 is allocated $500 to A and $500 to SP .

On January 1, 2008, SP ’s additional 10% interest in PRS is treated as becoming substantially vested under section 4.03 of this revenue procedure. At that time, the additional 10% interest in the partnership has a liquidation value of $350 (10% of $3,500). Under section 4.02 of this revenue procedure, the fair market value of the interest at the time it becomes substantially vested is treated as being equal to its liquidation value at that time for purposes of § 83. Therefore, in 2008, SP includes $350 as compensation income under § 83(a), PRS is entitled to a deduction of $350 under § 83(h), and SP ’s capital account is increased by $350.

(4) Example 4: Substantially Nonvested Interest; No § 83(b) Election

Conclusion : Under section 4.03 of this revenue procedure, SP ’s partnership interest is treated as substantially nonvested at the time of transfer. Because a § 83(b) election is not made, SP does not include any amount as compensation income attributable to the transfer and, correspondingly, PRS is not entitled to a deduction under § 83(h). Under proposed § 1.761–1(b), SP is not a partner in PRS ; therefore, none of PRS ’s taxable income for the years in which SP ’s interest is substantially nonvested may be allocated to SP . Rather, PRS ’s taxable income is allocated exclusively to A and B . In addition, the $50 paid by PRS to SP in 2005 is compensation income to SP, and PRS is entitled to a deduction of $50 under § 162 in accordance with its method of accounting.

On January 1, 2008, SP ’s interest in PRS is treated as becoming substantially vested under section 4.03 of this revenue procedure. Under section 4.02 of this revenue procedure, the fair market value of the interest at the time the interest becomes substantially vested is treated as being equal to its liquidation value at that time for § 83 purposes. Therefore, in 2008, SP includes $290 ($300 liquidation value less $10 amount paid for the interest) as compensation income under § 83(a), PRS is entitled to a $290 deduction, and SP ’s capital account is increased to $300 ($290

included in income plus $10 amount paid for the interest).

(5) Example 5: Substantially Nonvested Interest; § 83(b) Election

Facts : The facts are the same as in Example 4, except that SP makes an election under § 83(b) with respect to SP ’s interest in PRS . The liquidation value of the interest is $100 at the time the interest in PRS is transferred to SP . SP continues performing services through January 1, 2008.

Conclusion : Under section 4.02 of this revenue procedure, the fair market value (disregarding lapse restrictions) of SP ’s interest in PRS at the time of transfer is treated as being equal to its liquidation value (disregarding lapse restrictions) at that time for § 83 purposes. Because a § 83(b) election is made, in 2004 SP includes $90 ($100 liquidation value less $10 amount paid for the interest) as compensation income, PRS is entitled to a $90 deduction, and SP ’s initial capital account is $100 ($90 included in SP ’s income plus $10 amount paid for the interest). Under proposed § 1.761–1(b), as a result of SP ’s election under § 83(b), SP is treated as a partner starting from the date of the transfer of the interest to SP . Accordingly, SP includes in 2005 taxable income SP ’s $50 distributive share of PRS income, and the $50 payment to SP by PRS in 2005 is a partnership distribution under § 731. SP includes in 2006 and 2007 taxable income SP ’s $100 distributive shares of PRS income for those years.

(6) Example 6: Substantially Nonvested Interest; § 83(b) Election; Forfeiture; Net Profit

Facts : The facts are the same as in Example 5, except that SP terminates services on September 30, 2007, and is repaid the $10 that SP paid for the PRS interest in 2004. The partnership agreement provides that if SP ’s partnership interest is forfeited, SP ’s distributive share of all partnership items (other than forfeiture allocations) will be zero with respect to the interest for the taxable year of the partnership in which the interest is forfeited.

Conclusion : The tax consequences for 2004 through 2006 are the same as in Example (5) . As a result of the forfeiture in 2007, PRS is required under § 1.83–6(c) to include in gross income $90 (the amount of the allowable deduction on the transfer of the interest to SP ). In accordance with the partnership agreement, PRS also makes forfeiture allocations in 2007 to offset partnership income and loss that was allocated to SP and partnership distributions to SP prior to the forfeiture. Cumulative net income of $150 was allocated to SP prior to the forfeiture ($50 in 2005 and $100 in 2006) and SP received a total of $60 of distributions from PRS ($50 in 2005 and $10 in 2007 (the repayment of SP ’s initial contribution to PRS )). Under proposed § 1.704–1(b)(4)(xii), the total forfeiture allocations to SP is $100 of partnership loss and deduction, the difference between $50 ($60 of distributions to SP less $10 of contributions to PRS by SP ) and $150 (cumulative net income allocated to SP ). Pursuant to the partnership agreement, none of the partnership income for the year 2007 is allocated to SP . In accordance with § 83(b)(1) (last sentence), SP does not receive a deduction or capital loss for the amount ($90) that was included as SP ’s compensation income as a result of the election under § 83(b).

(7) Example 7: Substantially Nonvested Interest; § 83(b) Election; Forfeiture; Net Loss

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Facts : PRS has two partners, A and B, each with a 50% interest in PRS . On December 31, 2004, SP pays the partnership $10 and agrees to perform services for the partnership in exchange for a 10% partnership interest. Under the terms of the partnership agreement, if SP terminates services before January 1, 2008, SP forfeits any right to any share of accumulated, undistributed profits, but is entitled to a return of SP ’s $10 initial contribution. SP ’s partnership interest is not transferable. The partnership agreement provides that if SP ’s partnership interest is forfeited, SP ’s distributive share of all partnership items (other than forfeiture allocations) will be zero with respect to the interest for the taxable year of the partnership in which the interest is forfeited. At the time of the transfer, the liquidation value of the 10% partnership interest is $100, and SP makes an election under § 83(b) with respect to the interest. In 2005, PRS earns $500 of taxable income, which is allocated and distributed $225 to each of A and B and $50 to SP . In 2006, PRS has net taxable loss of $1,000, $100 of which is allocated to SP . PRS does not make any distributions in 2006. PRS has no items of income, gain, loss, or deduction in 2007, other than gross income recognized under § 1.83–6(c). SP terminates services on September 30, 2007, and is repaid the $10 that SP paid for the PRS interest in 2004. PRS does not make any distributions in 2007, other than the return of SP ’s $10 contribution.

Conclusion : Under section 4.02 of this revenue procedure, the fair market value (disregarding lapse restrictions) of SP ’s interest in PRS at the time of transfer is treated as being equal to its liquidation value (disregarding lapse restrictions) at that time for purposes of § 83. Because a § 83(b) election is made, SP includes as compensation income in 2004 $90 ($100 liquidation value less $10 amount paid for the interest), PRS is entitled to a $90 deduction under § 83(h), and SP ’s initial capital account is $100 ($90 compensation income plus $10 amount paid for the interest). Under proposed § 1.761–1(b), as a result of SP ’s election under § 83(b), SP is treated as a partner starting from the date of the transfer of the interest to SP . Accordingly, SP includes in 2005 taxable income SP ’s $50 distributive share of PRS ’s income, and the $50 payment to SP in 2005 is a partnership distribution under § 731. SP includes in computing 2006 taxable income SP ’s $100 distributive share of PRS ’s loss.

As a result of the forfeiture in 2007, PRS is required under § 1.83–6(c) to include in gross income $90 (the amount of the allowable deduction on the transfer of the interest to SP ). In accordance with the partnership agreement, PRS also makes forfeiture allocations in 2007 to offset partnership income and loss that was allocated to SP and partnership distributions to SP prior to the forfeiture. Cumulative net loss of $50 was allocated to SP prior to the forfeiture ($50 of income in 2005 and $100 of loss in 2006) and SP received a total of $60 of partnership distributions ($50 in 2005 and $10 in 2007 (the repayment of SP ’s initial contribution to PRS )). If PRS had unlimited items of gross income and gain, the total forfeiture allocations to SP under proposed § 1.704–1(b)(4)(xii) would be $100 of partnership income and gain, the difference between $50 ($60 distributions to SP less $10 of contributions to PRS by SP ) and -$50 (cumulative net loss allocated to SP ). However, PRS ’s only income in 2007 is the $90 of income recognized by

PRS under § 1.83–6(c), all of which must be used to make forfeiture allocations to SP . Under section 4.04 of this revenue procedure, in 2007, SP must include in ordinary income $10 (the difference between the forfeiture allocations that would be required under proposed § 1.704–1(b)(4)(xii) if PRS had an unlimited amount of gross income and gain, $100, and the actual forfeiture allocations to SP, $90). PRS is not entitled to a deduction for the amount ($10) that SP is required to include in income under section 4.04 of this revenue procedure.